Thursday, September 3, 2009

New uses for the CAPM

The theoretical model that finance economists developed by assuming that every investor rationally balances risk against reward — the so-called Capital Asset Pricing Model, or CAPM (pronounced cap-em) — is wonderfully elegant. And if you accept its premises it’s also extremely useful. CAPM not only tells you how to choose your portfolio — even more important from the financial industry’s point of view, it tells you how to put a price on financial derivatives, claims on claims. The elegance and apparent usefulness of the new theory led to a string of Nobel prizes for its creators, and many of the theory’s adepts also received more mundane rewards: Armed with their new models and formidable math skills — the more arcane uses of CAPM require physicist-level computations — mild-mannered business-school professors could and did become Wall Street rocket scientists, earning Wall Street paychecks.
--Paul Krugman, NYT Magazine, demonstrating what can happen when international trade theorists -- even Nobel laureates -- venture outside their specialty. To the lay reader: the CAPM is not used to price financial derivatives! And there are no physicist-level computations needed to apply it. The article also makes a hash out of what Keynesian economics actually is and its relationship to current government interventions, although it gets some points right.

1 comment:

Anonymous said...

I assume Krugman was referring to the original Black-Scholes paper, where they presented an alternative derivation using the CAPM.